Analysis: "Naked" CDS ban and euro zone calm

Mike Dolan

6 Min Read

LONDON (Reuters) - The surprising stability of euro government bonds this year owes much to the European Central Bank’s powerful pledge of support, but many wonder if regulation to limit speculation also plays a part.

An illuminated euro sign is seen in front of the headquarters of the European Central Bank (ECB) in the late evening in Frankfurt January 8, 2013. REUTERS/Kai Pfaffenbach

European Union regulators acted last November after two years fretting about financial derivatives called sovereign credit default swaps (SCDS), insurance-like contracts offering protection against the risk governments default, and suspecting they aggravated serial euro government debt crises.

A key argument was that in allowing punters to bet on and profit from a sovereign default without even owning the underlying bonds, the market was prone to speculation and overshoot that had unnerved investors and precipated the very creditor strikes, bailouts and even the defaults being bet on.

For many, it was like taking fire insurance out on a house you didn’t own and the uncovered nature of trading in this market introduced more than a little moral hazard.

As a result, the EU banned uncovered or “naked”, positions in sovereign CDS, in tandem with other reporting requirements and circuit breakers on “short selling” in other systemic securities such as bank stocks.

The financial industry, perhaps predictably, cried foul and said the ban would distort price information, hit market liquidity in SCDS and ultimately backfire by scaring off potential bond buyers who would feel less comfortable hedging as a result.

Five months on, however, many puzzle at how relatively stable euro zone government bonds have remained through at least two events - Italy’s inconclusive elections and the messy Cyprus bailout - that would previously have caused major ructions across the bloc’s sovereign debt markets.

That’s not to say SCDS markets are not functioning at all. Pricing there still suggests about a 70 percent probability of an eventual sovereign default in Cyprus, for example.

But some point out that SCDS and underlying bond market gyrations in recent hotspots such as Slovenia are much more in step.

For most investors, the announcement last August of ECB’s bond-buying backstop, or Outright Monetary Transactions, is the prime protector here. But it may also suggest that the sorts of financial derivatives and trading activity the wider public saw malfunction so spectacularly over of the past decade can be effectively tamed.

But in a surprisingly blunt paper, the International Monetary Fund weighed in strongly against the EU ban last week - saying it found little evidence that SCDS overall had been out of line with bond spreads and that for the most part premiums reflected the underlying country’s fundamentals - even if they reflected them quicker than the cash market.

“Overall, the evidence here does not support the need to ban purchases of naked SCDS protection,” it said in a special chapter on the subject in its latest World Economic Outlook.

Even though the IMF report said it found signs of overshoot in default insurance premia for “vulnerable European countries in times of stress”, it said it couldn’t make a direct case for this causing higher sovereign funding costs per se.

For the most part, it endorsed the industry line that the ban would create more distortions than it would resolve and that a drop in CDS volumes and liquidity, which it said was observable this year, may deter bond buyers fearful of less efficient hedging.

The hedge fund industry, represented by the Alternative Investment Management Association, was quick to say the report “essentially vindicated” the industry position.

IMF ADJUDICATION?

The IMF’s resolute support of the industry line, not only in its analysis but its recommendations, was starkly clear.

Among those claiming the market had aggravated sovereign funding pressures include Rouen Business School professor Anne-Laure Delatte, whose report last summer looking at Greece, Ireland, Portugal, Italy and Spain and claimed SCDS and bank CDS had played a dominant role in driving market sentiment:

“We obtain empirical support of an intuition, often heard from market practitioners, that CDS prices affect market sentiment and serve as a coordinating device for speculation.”

Curiously, she reckoned the EU ban itself was flawed in that it excluded bank CDS which often led sovereign speculation and also exempted dealer banks consider to be ‘market makers’.

And given that the top 15 dealer banks account for almost 90 percent CDS trading activity, one wonders whether anyone apart from this concentrated group and leveraged hedge funds were really affected much either way.

As the IMF and others point out, the size of notional SCDS outstanding - at about $3 trillion last June - was only about 6 percent of $50 trillion of total government debt. So does it matter to long-term investors?

Scott Thiel, Head of European and Global Bonds at the world’s biggest asset manager Blackrock, says he was instinctively against banning financial market activity that reduced price visibility. By changing his view of CDS price signals, he said, it limited his options in managing portfolios.

However, he also said he understood what regulators were trying to do and was equivocal about the overall impact.

“When investors ask me if we have been more or less active in derivatives over the past year, my general answer is ‘less active’ because of what’s happened with regulation,” said Thiel, who said he remains particularly bullish on Italian debt regardless.

“It certainly makes portfolio management less efficient but that may have positive and negative effects - we’ll see.”